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Health Reform for Beginners: The Employer Tax Exclusion

This is why people are bored by health care policy. This, right here. The fact that the central concept in health care reform relies on the differential tax treatment of health care benefits when provided by your employer. Even italicizing that sentence doesn't make it more interesting.

But the importance of the employer tax exclusion is simple enough: The hinge question in health care reform is "where do you get the money?" And the main -- and most controversial -- pot of money in health care reform comes from the employer tax exclusion.

That is, somehow, fitting. It is perhaps evidence of the chaotic, unplanned, irrational nature of our health care system that the most decisive piece of health care policy -- save maybe Medicare -- is a World War II-era tax quirk. The Roosevelt administration had instituted wage and price controls to prevent profiteering. Excess profits were taxed at mind-bogglingly high rates. Wages were frozen so employers couldn't offer raises. But the government decided to exempt health benefits from these rules. So corporations took their wartime profits and plowed them into health care benefits. In 1953, with the war over, the IRS tried to overturn the rule. Congress overruled the IRS.

healthinsurancesources.jpgAnd so here we are. If you walk out, on your own, and attempt to give your friendly neighborhood health insurer a dollar, you're taxed on that dollar. If your employer gives the health insurer that dollar on your behalf, that dollar is not taxed. As a result, getting health insurance through your employer became -- and remains -- a much better deal than purchasing it with your wages.

This created, as you might imagine, a massive employer-based health insurance market. In fact, it made employer-based insurance the default, as you can see in the graph on the right. This has been bad for three main reasons.

The first is that it's regressive. This is intuitive enough: The people who enjoy the tax break are employed. The people who enjoy the biggest tax break have employers buying them extremely comprehensive health benefits. Both types of people tend to be richer than people who are unemployed.

outofpocketcosts.jpgThe second reason is that routing health care through employers twists the system in all sorts of horrible ways. Individuals don't know how much their employer is paying for health care. They don't know how much they're not getting in wage increases. They don't know how much premiums are growing every year. (Out-of-pocket costs are a small fraction of total health care spending, as you can see in the following graph.) Protecting individuals from seeing the full cost of health care reduces the political pressure to reform the system. It leaves them more dependent on their employer and less able to start a new business or take a job with a small company.

The third reason is that the subsidy -- and that's what this is, a subsidy to employers who offer health care -- is very big, and quite hidden. In March 2007, the Joint Committee on Taxation estimated that ending all employer-related tax breaks for health care would raise $1.23 trillion between 2009 and 2012. That's more than $300 billion a year. That's much more than you'd need to pay for health care.

But it's a hard more to get your hands on. Doing so raises taxes on 60 percent of Americans. When John McCain proposed replacing it with a tax credit during the campaign, Barack Obama savaged him. Effectively. Now that Obama is president, however, he needs to capture some of this money for health reform. And so the current thinking is that you don't repeal the tax breaks. You just cap them. Maybe you cap it by income, so richer people pay more taxes. Or you cap it by the value of the health insurance plan, so premiums in excess of, say, $12,000 are taxed on whatever falls beyond the line. You argue over their regressivity rather than their very existence.

This concerns some unions, who have bargained for better-than-average benefits and don't want to see them taxed. It'll worry a lot of workers. It'll give opponents of health care reform the same attack line Obama used so effectively during the campaign. It'll give Obama's political people heartburn. But if you want to pass health care reform, it probably has to be done.

Further Reading: "Tax My Health Benefits. Please." by Jon Cohn.

"The Tax Exclusion for Employer-Provided Health Insurance: Policy Issues Regarding the Repeal Debate" by the Congressional Research Service.

"The Tax Treatment of Health Insurance: Early History and Evidence, 1940-1970" by Robert Helms.

"Limiting the Tax Exclusion for Employer-Sponsored Insurance Can Help Pay for Health Reform" by the Center for Budget and Policy Priorities.

(Graph credit: Kaiser Family Foundation.)

By Ezra Klein  |  May 21, 2009; 5:00 PM ET
Categories:  Health Economics , Health Reform For Beginners  
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Comments

Great work man. David Cutler probably couldn't have explained it to me better.

A tip though on the blog, when you've got multiple graphs, caption them as Figure 1, 2, etc., so your readers know what you refer to when you say "the following graph."

Posted by: tristanreed | May 21, 2009 6:48 PM | Report abuse

This is a great post: thanks. And I wasn't gonna register but I wanted to say congrats on the new digs. (But seriously, making people to register to comment on blogs? That's gotta be unconstitutional or douchy or something.)

Posted by: EricthePoliticalHack | May 21, 2009 9:46 PM | Report abuse

I was forced to read your blog by an over-imposing friend. To me, reading about economic and domestic policy sounds like a good substitution for a tranquilizer pill. Amazingly, I'm still awake, and now so caught up in health care reform, I'm moved to comment. I am confused by one thing: if the tax subsidy goes to employers, how would that raise the tax rates of the average individual? Thank you for a lovely read.

Posted by: bellabell | May 21, 2009 11:39 PM | Report abuse

I think you're underselling the "less able to start a new business or take a job with a small company." point. This is a huge drag on the economy. Thousands of talented, hard working potential Entrepreneurs are sitting in safe jobs with big companies rather than helping build the next big thing, because they can't in good conscience risk putting their family on whatever junk health insurance would be available to them. This is a point that should play well with traditionally opposed pro-business conservatives.

Posted by: jbrians | May 22, 2009 1:19 AM | Report abuse

bellabell,

Taking the subsidy away actually would hit both. Right now, an employer may pay 75-80% of your coverage. The employer gets a tax break on that amount, and it doesn't count as taxable income to you. Your 20-25% contribution is also not taxable.

Now, if I read this correctly, there are a couple of ways to get hit on this. If the employer continues to provide coverage, it will become taxable income for you. I'm not sure if they will still get a break (they deduct your pay from taxable income). Plus, your own contribution is now possibly taxable, depending on how this is done. You're paying additional taxes for the coverage in either case.

The employer could also discontinue coverage. This is already a competitive disadvantage to US employers, who have to compete with those in countries where healthcare is provided. If they discontinue coverage, you may or may not get a raise to make up the difference. Either way, cost of coverage is now out of your pocket, generally without any tax breaks.

This is a big reason that this subsidy can only be ended as part of a larger reform effort. Everyone who has employer-provide coverage (a lot, per Ezra's graphs) gets hosed. There has to be a way to unhose them while also extending coverage to the uninsured. Otherwise, eliminating this is political suicide.

The Wyden-Bennett plan, probably among others, eliminates this subsidy but has a backup plan to replace it (theoretically).

Posted by: J-NC | May 22, 2009 11:35 AM | Report abuse

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